Topic 9 - BMGT 343: Investments Prof. Anna Obizhaeva...

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1 Market Efficiency Anna A.Obizhaeva BMGT 343: Investments Prof. Anna Obizhaeva Office: VMH 4428 Phone: (301) 405-7934 Email: [email protected] Section 0101 T Th 9:30-10:45 am in VMH 1336 Section 0201 T Th 11:00-12:15 pm in VMH 1336 Section 0301 T Th 12:30-1:45 pm in VMH 1336 Office Hours : Thu 3:00-4:00 pm or by appointment Market Efficiency Anna A.Obizhaeva Market Efficiency Topic 9: Market Efficiency
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2 Market Efficiency Anna A.Obizhaeva General Overview In the previous topic, we studied the CAPM – one of the frameworks that provides us with the intuition on what the expected returns should be. The CAPM allows to find whether securities are underpriced or overpriced. Market Efficiency Anna A.Obizhaeva General Overview (cont’d) Question: which stocks would you recommend to buy and to sell?
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3 Market Efficiency Anna A.Obizhaeva General Overview (cont’d) If we buy underpriced securities and sell overpriced securities can we make money ? Market Efficiency Anna A.Obizhaeva Different Answers Professionals insist that they can win when they invest actively, as opposed to buying and holding a broadly diversified portfolio, because they can distinguish trends from noise and make better sense than amateurs out of new information. Is it indeed true? Academics are more skeptical. They refer to the market efficiency .
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4 Market Efficiency Anna A.Obizhaeva Outline for Topic 9 Definitions of efficient market hypothesis (EMH) The three forms of EMH Statistical tests of EMH Questions and practical issues about EMH Market Efficiency Anna A.Obizhaeva 1. Definitions of Market Efficiency We need to define what we mean by “Can we make money trading stocks”? One definition: We can make money == We can find a ( riskless ) arbitrage
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5 Market Efficiency Anna A.Obizhaeva Definition (cont’d) We adopt a broader definition: We can make money == We can achieve an expected return which is “large” relative to the risk . Market Efficiency Anna A.Obizhaeva Ab normal Returns • When is expected return large relative to risk? • To answer this question, we have to adjust expected returns for risk. • For instance, we can use the CAPM: - Adjustment for risk for asset n is - Where is the beta of an asset n : - MRP is the market risk premium: ( ) f M R R E MRP = MRP n × β ( ) ( ) M M n n R V R R Cov , = n
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6 Market Efficiency Anna A.Obizhaeva Ab normal Returns (cont’d) Then, abnormal return of asset n is Expected return is large relative to risk, if abnormal return is large (i.e., alpha is large and statistically significant). Important : Note that the definition of abnormal return is somewhat subjective. It depends on what we think the true model of expected returns is. (We used the CAPM but we could use the Fama-French model or other models). ( ) f
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This note was uploaded on 12/02/2011 for the course BMGT 343 taught by Professor Staff during the Fall '08 term at Maryland.

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Topic 9 - BMGT 343: Investments Prof. Anna Obizhaeva...

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